Bankers and regulators debate the future of finance

IESE Dean Jordi Canals adresses a closed forum on the Challenges for the Future of Banking / Photo: Iñigo Alcañiz

The 1988 Basel Accord, a set of rules aimed at addressing risk within the banking sector, ran to 300 pages. Its successor, BASEL II, reached over 700. In 2010 the BASEL III rule book had swollen to over 30,000 pages.

This exponential increase highlights the intensely complex nature of today’s financial systems and the new, highly regulated environment under which global financial institutions now operate.

So, do growing levels of regulation stifle innovation within the banking sector? How far can mandated increases in capital and changes to debt-to-equity ratios address systemic risk?

Are today’s institutions appropriately structured for tomorrow? And with public confidence in the sector at rock bottom, what can the industry do to regain trust?

Seeking answers to these crucial questions, policy-makers, regulators and European banks came together in London’s Somerset House on 27 November 2014. On the agenda, in this intimate event organised by IESE and conducted under Chatham House rules, were the "Challenges for the Future of Banking."

Among the attendees were: Andrea Enria, Chairperson of the European Banking Authority; Professor Jeremy Stein, Moise Y. Safra Professor of Economics at Harvard University and former member of the Board of Governors of the Federal Reserve System; Deputy Managing Director for Banking at the European Stability Mechanism, David Vegara; and Professor David Miles of Imperial College and member of the Bank of England’s Monetary Policy Committee.

Banking After the Crash

The financial sector has seen regulation dramatically increase since the crash of 2007. Institutions have become more conservative, and, according to some speakers, innovation – the lifeblood of the sector – is being "stifled."

While it was agreed that these were natural responses to the excessive risk taking of the pre-crash era, addressing systemic risk in this highly complex and interdependent system requires a new level of understanding: not just of cause and consequence, but of risk itself.

For our first speaker, the need for open and wide debate on reforms within the banking sector was crucial. Events of 2007 had radically reshaped the landscape, evidenced in moves to eliminate capacity and debt overhang, dramatic changes in management and a greater focus on bringing industry and regulators together to define new intervention and resolution pathways. Rather than focusing on "too big to fail" strategies backed by government, he favored an approach that would allow failed institutions to exit the market smoothly.

Of course, the best case would be to avoid insolvency issues at all – and to do so our second speaker urged we take a holistic view of risk.

Risk Re-Evaluated

Even before the crash, the nature of risk was changing, he said. The digital revolution and the disintegration of political, economic and other walls had already created a tremendously complex risk environment.

Managing financial services in the 21st century was by its very nature deemed a risk management exercise – and addressing and understanding this changed environment was both a public and private sector responsibility.

However, skepticism remained about whether the actions so far taken would stop the next crisis. The idea of eliminating the threat altogether was taken up by the room, with many saying that future failure within the banking system, or within individual institutions, was inevitable. The task, therefore, was to address systemic risk to as great a degree as possible, and create an environment where failures could occur without the onerous consequences of 2008.

Restructuring Banks: The Challenges of Ring-Fencing

The structure of institutions also came under the spotlight, with specific regard to ring-fencing segments of activity. Here two separate but connected dimensions where discussed – functional ring-fencing to limit financial interactions between different activities and business units, and geographic ring-fencing to limit cross border exposures and financial flows.

While the EU is in the early stages of considering legislation on Banking Structural Reform (activities that would create a new framework for ring-fencing), opinion in the room favored caution to avoid inconsistencies with on-going regulation.

Added to this, the complexity and interrelationships between ordinary bank business and investment areas are such that separation, on any level, was seen by some as a major challenge. Moreover, the international dimension raised questions of whether ring-fencing regulation could, and should, be adopted globally.

How Much Capital is Enough?

The crisis brought into sharp relief the need for banks, and their shareholders, to shoulder potential losses - rather than governments and their tax paying citizens. The question was: how much capital is enough?

The banking leaders, academics and regulators in the room where in general agreement about the need for institutions to maintain appropriate debt-to-equity leverage ratios. However, the levels of capital, and the costs of a high leverage ratio caused much discussion.

While the regulators saw undoubted cost to institutions in holding higher levels of capital, one speaker remarked that recent history shows the humbling economic cost of failing to do so. In his opinion, banks should simply swallow the costs.

Rebuilding Reputations and Restoring Trust

How can the industry regain the confidence of citizens? Here, panellists highlighted a clear disconnect between personal relations between individuals and their bank, and negative public perception of the industry as a whole.

Everyone agreed on the need for banks to start "coming clean." Panelists pointed to continuing and widely reported scandals - such as LIBOR rigging problems – as adding oil to the flames of negative public opinion. Banks continue to have legacy challenges and, if was felt, these should be admitted in the first instance, and resolved in the second.

Similarly, while the growth of Internet banking offers significant retail banking convenience for consumers, this digitization was seen to cause a growing detachment between the customer and bank. Developing new and more effective customer engagement strategies was a major priority for banks looking to turn the tide.

The room agreed on the challenges of operating within an interconnected system. A single institution, for instance, embarking on a public engagement strategy will have little success if such initiatives are not adopted industry wide. Similarly, while one bank may be making great strides to improve ethicacy within its operations, if other are not, public opinion is destined to remain routed in the negative.

Regulation: The Road Ahead

Throughout the conference, regulation was never far from discussion. While speakers and delegates supported the need for tighter regulation, there were notes of concern as to the volume and complexity of regulation, and the "combative approach" of regulators.

The unintended consequences of a more straightened regulatory environment were also seen to be problematic – from institutions reducing their service portfolios, investing less time in developing new services or moving operations from higher risk geographies altogether.

The message from the banking sector was clear and consistent: the way forward should be built on a light regulatory touch that delivers a clear framework and transparent penalties.